Why Taiwan Semiconductor Is a Core Holding For Your Portfolio

Intel (NAS: INTC) is unique. Not only because it manufactures standout chips, but also because it manufactures hundreds of different processor designs. Almost no one else in the industry does, choosing instead to outsource to an Asia-based contractor, and Taiwan Semiconductor Manufacturing Company (NYS: TSM) gets most of the calls.

The business
Founded by former Texas Instruments engineer Morris Chang 25 years ago, TSMC is to contract chip manufacturing what Intel is to chip design.

As of this writing, the company operates five chip manufacturing facilities -- or "fabs" -- with two more in production and a U.S. subsidiary based in Washington State. TSMC is also invested in Singapore's Systems on Silicon Manufacturing with NXP Semiconductors and building a new advanced production facility in central Taiwan that's due to open next month.

Each facility is scaled and customized to mass-produce chips designed elsewhere. Apple leads the list of notable new clients. Last summer, the Mac maker inked a deal to have TSMC manufacture its A6 processor based on ARM Holdings' (NAS: ARMH) popular low-power mobile chip architecture that Microsoft is porting to Windows 8.

Dozens more ARM designers use TSMC, and for good reason. In July 2010, the two companies signed a long-term technology-sharing agreement intended to simplify and speed the process of bringing new ARM designs to market.

Why it's a core holding
Deep relationships like this are what place TSMC head and shoulders above peers Semiconductor Manufacturing International (NYS: SMI) and United Microelectronics (NYS: UMC) in almost every financial category that matters. Here's a closer look: 

Metric

TSMC

SMI

UMC

Revenue (TTM) $14,178.4 million $1,454.5 million $4,100.3 million
Gross Margin 46.7% 15.4% 23.1%
Free Cash Flow (TTM) ($1,091.5 million) ($786.4 million) ($1,050.9 million)
Cash / Debt (millions) $4,972.8 / $675.5 $315.7 / $1,093.5 $1,850.2 / $1,171.9

Source: S&P Capital IQ. TTM= Trailing twelve months. Cash flow is levered cash flow calculated by Capital IQ.

Look at the last two rows in particular. Chip design and manufacturing is a cyclical business whose ups and downs can destroy a balance sheet. Over the past 12 months alone -- as the PC market has taken a turn for the worse worldwide -- each of the major contract manufacturers has bled at least $700 million in free cash flow when adjusting for debt and working-capital requirements. Yet it's only TSMC that sports significantly more cash than debt, allowing management to wait out the downturn, continue investing in higher-grade equipment, and pay a dividend yielding 3% or more.

The combination is what makes Taiwan Semiconductor a core holding. It's also why I've owned shares since June of 2006. Reinvesting over the ensuing five years since has cut my cost basis to just $7.09, resulting in a near double at current prices. I plan to keep holding, and keep reinvesting, so long as TSMC keeps the advantages I've noted above while paying dividends.

Risks to watch
Notice the qualifier in there. My plan is to hold for as long as Taiwan Semiconductor continues to benefit from scale in winning partners. Could anything erode this advantage? Intel could cause trouble by opening up more of its facilities to outside chip manufacturing. China could also pour more money into hometown SMI, offsetting its balance sheet disadvantages.

Yet TSMC has long faced off against alternative suppliers only to win deals for how it brings advanced equipment online faster. Consider the new fab under development near its Taiwan headquarters: Reports say it will be outfitted to manufacture chips at 40 nanometers and 28 nanometers, about as small as anyone in the industry is operating right now. And that includes Intel, whose mobile-centric Medfield chips are 32 nanometers.

Making the call: Buy
My point? Chip designers creating high-function processors are unlikely to choose anyone other than TSMC because of its technology advantages, which result directly from a rich balance sheet and aggressive investment in new fabrication facilities.

In other words, Taiwan Semiconductor is a durable franchise. Isn't that what you should want out of a core stock? I think so, and I'm sticking both with my real-money shares and the outperform CAPScall I made around the time of my original purchase.

Do you agree? Disagree? Either way, you needn't look overseas to find great winners. The Motley Fool has identified a handful of prospects right here on our shores in a new report entitled "3 American Companies Set to Dominate the World." The research is free, but only for a limited time, so click here to get your copy now.

Add Taiwan Semiconductor Manufacturing to My Watchlist for up-to-the-minute Foolish coverage of the stock and of your entire portfolio.

At the time this article was published Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Apple and Taiwan Semiconductor at the time of publication. Check out Tim's Web home, portfolio holdings and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.The Motley Fool owns shares of Microsoft, Texas Instruments, Apple, and Intel. Motley Fool newsletter services have recommended buying shares of NXP Semiconductors, Microsoft, Apple, and Intel. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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